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Annuity Anomaly: EIA + GLB > SPIA?

My mother sends me all sorts of strange emails, ranging from health and weight tips to YouTube videos of animals doing bizarre and unnatural things. I’m sure your retired mom does the same. But a few weeks ago she quite frankly stepped over the line. In a 7MB email, she sent me a legal prospectus for an equity-indexed annuity (EIA). Heavens!

Actually, what she did was forward to me an email from a neighbor of hers—who happens to be a licensed insurance agent—who was trying to sell her an EIA. Now, let me make it quite clear: Despite the genetic connection and all, my mom really isn’t the financial type. So, the email with six PDF attachments and numerous spreadsheets included a brief note from her: “He is a very nice man. Do you think this is a good idea?”

The first thing that came to my mind—after “you have got to be kidding me”—was to channel Humphrey Bogart’s line in Casablanca, “From all the geriatric joints in all the world this guy had to step into my mom’s?” Hey, where is FINRA where you need them?

Tasting blood, I reached out to the aforementioned nice man (having learned from Reese Witherspoon not to start with: “Do you know who I am?”) and asked a simple question: “EIA? For income, why not a life annuity?” After all, a life annuity is the cheapest and most efficient way to generate a guaranteed lifetime of income, because of the risk pooling, mortality credits, etc.

Alas, here is where things got interesting. The nice man countered that an equity-indexed annuity purchased together with a guaranteed living benefit (GLB) rider, might ­actually provide more guaranteed income than a single premium income annuity (SPIA).

“Yeah, right” was my gut reaction. Had he not heard of no-arbitrage relations, put-call parity and all the no-free-lunch identities we indoctrinate into our graduate students in finance? Heck, that would be like gravity being reversed or the Maple Leafs winning the Stanley Cup.

But lo and behold, after much back and forth, it seems he was right. Occasionally there are insurance (mis)pricing anomalies. The EIA + GLB combination at the right age and for the right person can occasionally dominate or come within inches of an SPIA. Allow me to elaborate.

EIA Background

The EIA—which is also known as a fixed indexed annuity (FIA)—is the Rodney Dangerfield of the already maligned annuity universe. If you Google either EIA or FIA or some other permutation, you will stumble across dozens of recent enforcement actions against advisors who have misrepresented and mis-sold them, including the occasional jail sentence!

In fact, looking back at the many ­articles I have written about annuities in the past few years, the vast majority of them have focused on variable annuities (VAs) with guaranteed lifetime withdrawal benefit (GLWB) riders, single premium income annuities or my academic favorite, advanced life delayed annuities (ALDAs). I haven’t given much ink or attention to equity-indexed annuities, partially due to their perceived toxicity. Why get involved?

And yet, EIAs were a $35 billion (in sales) business in 2012, according to LIMRA. Sure, that isn’t as large as the $147 billion VA business, but it certainly trumps the $7.7 billion of immediate annuities sold in 2012. The big players in the EIA space include Aviva, American Equity, Security Benefit and Allianz, along with other household names. More to the point, approximately 75% of EIA buyers are now electing (and paying for) a lifetime income rider such as a GLB. It’s time to have an opinion.

Boiled down to its economic essence at the 50,000-foot view, the EIA + GLB combination is quite similar to a variable annuity with a guaranteed living withdrawal benefit. In both cases the client hands over a sum of money to an insurance company, a premium that is invested on behalf of a client. As with the VA, the insurance company keeps track of and reports two numbers on the statement. The first is the actual account cash value and the second is the hypothetical benefit base.

Clients can access the account value at any time as long as they are willing to forfeit some (initially steep) surrender charges. In contrast, the benefit base is used to determine clients’ guaranteed lifetime income if and when they turn on the rider. The longer they are willing to wait, the higher the benefit base is likely to be and the more income they can expect for life. Once again, I could be describing either a VA + GLWB or an EIA + GLB.

Yes, I know that with an EIA you don’t have much choice in terms of the investment allocations, which are usually linked to an S&P 500 index ­minus any dividends, while the VA gives you a robust line-up of many different funds and subaccounts. And yes, the EIA ­imposes low caps and tight participation limits on the growth of the account value, which reduces the probability you will get anything more than the guaranteed minimum. Also, one is a security while the other is an insurance policy. These are important, but secondary, details.

I should point out that as ­insurance companies continue to place asset ­allocation restriction on the sub-­accounts within the VA + GLWB and policy-holders are given less freedom to ­allocate and move money around, the actual performance of these accounts might soon resemble a neutered and passive equity index.

From an insurance company ­accounting point of view, though, there is an important difference between what the company does with the VA money versus the EIA premium. In the former the company places the funds in a separate account and has to worry about hedging the downside risk. In the latter, the company places the funds in its general account and then has to worry about crediting you with interest on the upside. And, while financial economics might dictate that these are identical exposures, in practice things can be different depending on how the crediting formula is structured.

In fact, this is why you can occasionally find EIA + GLB combinations offering more income relative to a VA + GLWB, which shouldn’t be too surprising given the difference in underlying accounts, liquidity provisions, etc. But the irregularity that attracted my attention was EIA + GLB versus the SPIA.

Beat the SPIA

The table nearby provides some indicative quotes where the guaranteed minimum income from an EIA + GLB is compared to the guaranteed income from a SPIA. Take for example a 65-year-old couple with $500,000 dedicated to buying a life annuity, with income starting in 36 months (perhaps when they plan to retire).

The average payout quote for a joint-and-last survivor annuity was $30,390 per year, which is a payout of (approximately) 6% for as long as either of them lives. Now look at the column which says EIA. It offers the same couple a payout of $31,750 per year (starting in 36 months), continuing for as long as either of them is alive. This is about 5% more than the SPIA, but also offers upside potential.

Namely, if the underlying index does well (OK, more like a triple-lutz-triple-toe jump) in the next 36 months, the benefit base will be higher—but never less. Also, being an EIA it offers some liquidity and is cashable. Of course, you have to pay steep surrender charges, but remember, the SPIA would have offered you no liquidity whatsoever. Ergo, I consider this an anomaly that can’t be explained by credit risk or default concerns because all quoted companies were in the same risk bin.

Now, this EIA + GLB > SPIA anomaly doesn’t apply at all ages. Notice that at higher ages such as 70 and 75, the payouts from the SPIA dominate the guaranteed payouts from the EIA for single lives, as they should, although they are quite close for joint lives.

Needless to say, the table is just a snapshot in time for a few companies, so it’s difficult to make general statements about the exact ages at which one option dominates the other, but this does happen, especially for joint lives.

Rational Explanation

The reason an EIA can guarantee a lifetime payout that is higher than a SPIA for younger females and/or a longer delay period, is partially due to the assets backing an EIA versus a SPIA and partially because of the unisex and lapse-supported nature of the EIA + GLB pricing.

SPIAs are sold and priced based on more conservative assets and with the unique age and gender of the ­annuitant, while EIA + GLB are more loosely organized into pricing bands and are not priced to be gender specific. Moreover, the insurance companies assume that some policyholders will surrender their EIAs before they ever convert them into income, which allows them to offer just a wee bit more to the rest. Add this all together and you find that younger females might get more, relative to a SPIA which is priced with zero lapsation and calibrated to an exact age.

And remember, the numbers in the table are only the guaranteed payouts for the equity-indexed annuity. If the underlying (S&P 500) equity index moves up at the right time and at the proper speed—no matter how remote you gauge the probability—the guaranteed lifetime income will be higher.

Here is the bottom line. If you strip out the shady sales practices and the 15-year surrender charges, underneath it all is an intriguing insurance proposition for advisors who are willing to understand and wade into a (potential) minefield.

Now, I want to be crystal clear here, lest readers suspect that I was hit on the head with a hockey stick and am suffering from an intellectual concussion. I am not saying that an equity-indexed annuity is better than a variable annuity with a GLWB. That is an apple to pineapple comparison. My point is rather modest. Sometimes insurance pricing can be weird. Take advantage of it. So, before you pull the trigger on an irreversible life annuity for a younger client—especially if you are piling on refunds, period certain and guarantees—you might want to run a quote for an EIA + GLB. Like me, you might be surprised.

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